The covenant quality of high-yield bonds issued in North America fell to its weakest level last month, with investors apparently increasingly willing to forgo security for the sake of fatter yields, according to a report by Moody’s Investors Service.
In July, the credit ratings agency said its Covenant Quality Index (CQI) — or level of investment protection — weakened to 4.37 from 4.25 in June.
The index is a three-month rolling average score weighted by each month’s issuance volume.
Evan Friedman, Moody’s vice president and senior credit officer, said: “This trend of weak covenant protections continues to reflect a large percentage high-yield lite transactions.
“Investors are trading away their protections in search of yield,” he said.
‘Lite’ or ’covenant lite’ lending describes deals that do not contain the usual protective covenants for the benefit of the lender.
Moody’s measures bond covenant quality on a scale from 1.0 for the strongest investor protection down to 5.0 for the weakest.
High-yield lite bonds automatically receive the weakest possible score of 5.0, it says, because these bonds lack debt incurrence — meaning their issuance does not stop the issuer being able to take on extra debt at the same seniority — and, or, restricted payments covenants, the lack of which means the borrower is not limited in its ability pay dividends, distributions etc.
The agency said in the report that its average monthly covenant quality score had deteriorated to 4.60 in July, which was a new monthly record low, even though it cautioned that there had only been a low level of issuance in July with just 16 bonds scored.
Scores also weakened for bonds with full covenant packages, according to the report.
The covenant quality of these full-package bonds included in the CQI sank to a record low of 4.14 in July, it said.
This fall had been driven by a worsening of the leveraging and liens subordination risk categories, Moody’s said.
On top of this, the covenants of Ba- and B-rated bonds continued to offer only the weakest investor protection, it said, with the average score in July for those bonds at 4.96 and 4.45.
The keen search by investors for yield in a period of extremely low and even sub-zero yields on government bonds has led to record growth in European leveraged loan and high-yield bond markets.